Common Factors in Equity Option Returns

Abstract

This paper studies the factor structure of the cross-section of delta-hedged equity option returns. We develop a parsimonious factor model that explains the cross-section and time-series of equity option returns. The model contains four factors. Three are characteristic-based factors from the long-short option portfolios based on Firm size, idiosyncratic volatility, and the difference between implied and historical volatilities. None of these factors is spanned by the factors in equity returns and suffice to capture the cross-section of options returns. The fourth factor is the market volatility risk factor proxied by the delta-hedged option return of the S&P 500 index that explains the timeseries of option returns.